Watch out for taxes in retirement

By Jason Alderman

Wouldn't it be nice if, after decades of hard work and saving, you could retire without worrying about paying taxes? Alas, that'll probably never happen.

Even if your income drops significantly post-retirement, chances are you'll still be taxed on a portion of it. And, depending on where you retire and your income sources, you'll probably also face additional taxes on purchases, real estate, capital gains, inheritances – the list goes on.

Consider these tax-related issues when budgeting for retirement living expenses:

Social Security. Most people can collect Social Security benefits as early as age 62, although you drawing benefits before your full retirement age will significantly lower your benefit amount. ("Full retirement age" is 65 for those born before 1938 and gradually increases to 67 for those born in 1960 or later.)

Although many states don't tax Social Security benefits, they are counted as taxable income by the federal government. So, depending on your overall income, you may owe federal tax on a portion of your benefit. The formula is complicated, but basically:

Single people whose combined income from all sources is less than $25,000 are not taxed on their Social Security benefit.

For combined income between $25,000 and $34,000, up to 50 percent of your benefit may be taxed.

For income over $34,000, up to 85 percent may be taxable.

For married people filing jointly: benefits aren't taxable for combined income below $32,000; benefits between $34,000 and $44,000 are up to 50 percent taxable; benefits over $44,000 are up to 85 percent taxable.

For more details, read the IRS Tax Topic 423 and Publication 915 at www.irs.gov.

After beginning to collect Social Security, some people can't make ends meet and must return to work, which can backfire: If you earn more than $14,160 a year, you'll lose one dollar of Social Security benefits for every two dollars earned over that amount. (Note: Investment income doesn't count.)

Thus, if you need to continue working, it may be wiser to postpone Social Security until reaching full retirement age. Such benefit reductions aren't completely lost, however: Your benefit amount will be increased upon reaching full retirement age to account for benefits withheld due to earlier earnings. To learn more, read "How Work Affects Your Benefits" at www.ssa.gov.

IRA and 401(k) withdrawals. After age 59 ½, you can start withdrawing from your IRA or 401(k) without paying the 10 percent early withdrawal penalty. However, you will pay federal (and state, if applicable) income tax on the withdrawals – unless it's a Roth plan, whose contributions have already been taxed.

Other taxes. Some people move to another state after retirement to their tax burden. For example, seven states don't tax personal income (although two others do tax dividend and interest income). And five states charge no sales tax. But because other taxes and cost-of-living expenses vary significantly by community, you should only consider such moves after doing thorough research.

The Retirement Living Information Center (www.retirementliving.com) features a state-by-state breakdown of the various taxes seniors are likely to pay, including those on income, sales, fuel, property, inheritances, etc.

Bottom line: Be sure to include taxes among the many expenses you need to plan for at retirement.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.